Prospect theory and stock returns: A seven factor pricing model

Abstract

The single-factor Capital Asset Pricing Model (CAPM), and its multi-factor extensions, are models that seek to explain investor's expectations for returns on risky assets. Empirical studies however, show that these factor models do not fully explain variations in expected returns. We show that a simple two factor model, based on the Peak-end rule (Fredrickson & Kahneman, 1993) from Prospect Theory (Kahneman & Tversky, 1979, 1992) explains variations in asset returns more thoroughly than the CAPM or it's extensions. Our results are derived from an extensive study on all US listed securities over the time period of 1927–2014. Based on our findings, we propose a Seven-Factor asset pricing model merging the insights of Expected Utility Theory, and Prospect Theory. Our new model explains variations in asset returns more comprehensively than the CAPM and its extensions including the recently established five factor CAPM by Fama and French (2015).